What is the Gross Profit Margin?
The Gross Profit Margin represents the amount of revenue left over after deducting the cost of goods sold (COGS) incurred in the period.
Since only direct costs are accounted for in the metric, the gross margin shows how much in profits remains available for meeting fixed costs and other non-operating expenses.
- What is the formula used to calculate the gross profit margin?
- How might you determine what a “good” gross profit margin is for a specific company?
- What are the limitations to the gross margin as a measure of profitability?
- What is the difference between the gross margin and net profit margin metrics?
Table of Contents
Gross Profit Margin Formula
The gross profit margin, or “gross margin” for short, answers the following question:
- “How much in gross profits is kept for each dollar of revenue?”
The formula for the gross margin is the company’s gross profit divided by the revenue in the matching period.
Gross Margin Formula
- Gross Profit Margin = Gross Profit / Revenue
The gross profit is calculated by subtracting direct costs (COGS) from revenue, with direct costs referring to expenses directly tied to the production and delivery of specific goods and/or services (typically variable costs).
The COGS are matched to the associated revenues in the same time period, which is commonly known as the “matching principle” of accounting.
Examples of COGS include the following:
- Direct Labor Costs
- Purchase of Materials (i.e. Inventory)
Typically, the gross margin is expressed in percentage form, which can be calculated by multiplying the resulting decimal value from the equation above by 100.
For a given period, the revenue and gross profit of a company will be found directly at the top of the income statement.
- Less: Cost of Goods Sold (COGS)
- Gross Profit
For example, if a company has generated $10 million in revenue with $3 million in COGS, the gross profit is $7 million.
Upon dividing the $7 million in gross profit by the $10 million in revenue and then multiplying by 100, we arrive at 70% as our gross margin.
Based on the 70% gross margin, we can gather that the company has earned $0.70 in gross profit for each $1.00 of revenue.
Apple Gross Profit Example
Apple Gross Profit (Source: WSP Financial Statement Modeling)
Interpreting the Gross Profit Margin
Interpreting a company’s gross margin as either “good” or “bad” depends substantially on the industry in which the company operates. For any comparisons of gross margins to be useful, the companies must operate in the same or similar industry with available historical data dating back several years to get a better sense of the industry norm (and patterns).
For example, software companies have been known for having high gross margins, while clothing retailers have historically exhibited razor-thin gross margins and rely on volume to remain profitable.
Service-based industries also tend to have higher gross margins since the COGS for such businesses are minimal (e.g. consulting firms), whereas capital-intensive companies (e.g. manufacturing, industrials, retail) normally have lower gross margins due to margin erosion from the direct costs related to building up inventory, manufacturing products, etc.
Nevertheless, industries with significant direct costs can still consist of market leaders with consistent profits that retain meaningful market shares (e.g. airlines, transportation, retail).
Higher gross margins are usually viewed in a positive light, as the potential for higher operating margins and net profit margins increases. An accurate assessment of the gross profit metric depends, however, on understanding the industry dynamics and the company’s current business model.
Methods to Increase Gross Margin (%)
Three methods for companies to increase their gross margin are:
- Increase Average Selling Price (ASP) – Requires Pricing Power, Upselling, etc.
- Purchase Inventory at Lower Prices – Requires Negotiating Leverage with Suppliers (e.g. High Order Volume/Frequency, Bulk Purchases, Branding)
- Integrate Higher Margin Products/Services – Adding New Products/Services with Higher Gross Margins Could Lead to Improved Customer Retention and Cross-Selling Opportunities
Gross Profit Margin vs Net Profit Margin
In contrast, the gross margin accounts for just one outflow of cash, which is the direct costs associated with the production of revenue.
The gross profit metric tends to be better suited for peer comparisons since there is far lower potential for manipulation via discretionary accounting decisions by management.
The gross margin, unlike the net margin, is largely unaffected by financing decisions or discretionary accounting policies such as useful life assumptions for purchases of PP&E or differences in the tax rate.
Gross Profit Margin Calculator – Excel Template
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Gross Profit Margin Example Calculation
For our example modeling exercise, we’ll be calculating and comparing the gross margin of three companies, with each having different revenue and COGS assumptions.
The calculation process is as follows:
- First, we must take the net revenue and the cost of goods sold (COGS) figures from the income statement.
- Next, we’ll calculate the gross profit by subtracting COGS from revenue.
- Lastly, we’ll divide the gross profit of each company by the amount of revenue in the corresponding period to quantify the gross margin.
To begin, we’ll start by listing out the revenue and cost of goods sold (COGS) assumptions for each company.
Income Statement – Company A
- Revenue: $200m
- Cost of Goods Sold (COGS): –$80m
Income Statement – Company B
- Revenue: $200m
- Cost of Goods Sold (COGS): –$60m
Income Statement – Company C
- Revenue: $200m
- Cost of Goods Sold (COGS): –$100m
Using these figures, we can calculate the gross profit for each company by subtracting COGS from revenue.
- Company A – Gross Profit: $200m – $80m = $120m
- Company B – Gross Profit: $200m – $60m = $140m
- Company C – Gross Profit: $200m – $100m = $100m
Next, the gross profit would be divided by revenue to get the gross margin.
- Company A – Gross Margin: $200m ÷ $120m = 60.0%
- Company B – Gross Margin: $200m ÷ $140m = 70.0%
- Company C – Gross Margin: $200m ÷ $100m = 50.0%
Despite the differences in operating expenses (OpEx), interest expenses, and tax rates among these companies, none of these differences are captured in the gross margin.
The gross margin isolates the profits only after COGS is factored in, which makes the metric more informative for peer group comparisons.
Since COGS were already taken into account, the remaining funds are available to be used to pay operating expenses (OpEx), interest expenses, and taxes.
For instance, the operating profit margin, which accounts for COGS and OpEx, is 20% for Company A, 35% for Company B, and 5% for Company C.
As in the case of all profitability metrics, the gross margin should be used in conjunction with other metrics to fully understand the cost structure and business model of the company.